06 February 2014

Fractional reserve bullion banking and gold bank runs - unallocated as real (gold) bills

I must apologise for jumping around a bit with these posts on fractional reserve bullion banking. I haven’t planned this series out and each day I think of additional things worth noting if one is to have a more nuanced understanding of how a gold run would play out. I’ll get there in the end.

So another slight diversion. I forgot to mention in this post that BBs can create gold credit (ie unallocated) just like with fiat currencies. So their gold balance sheet can consist of unallocated liabilities backed by promises to repay gold. "That sounds fraudulent" I hear you say. A practical example may help.

Consider a simple world with one Miner, one Refiner, one Bullion Bank, and an Investor.

A Miner delivers dore to the Refiner for refining. Due to competition, these days Refiners pay Miners for their dore once an assay has been completed, which is usually in a couple of days and well before the Refiner has been able to actually refine the dore. The assay reveals that the dore contains 12oz of pure gold and the Refiner quotes an outrageous  (but easy for me to calculate) charge of 2oz in refining fees.

As the Refiner does not have any gold to pay the Miner, it asks the Bullion Bank for a 10oz gold loan. The Bullion Bank agrees to do so at an outrageous rate of 10%, and creates unallocated gold credits out of thin air. At this point the Bullion Bank’s balance sheet looks like this:

Asset – 10 oz Loan to Refiner
Liabilities – 10 oz of Unallocated to Refiner

The Refiner then instructs the Bullion Bank to transfer unallocated gold to the Miner, as payment for the dore (usually done via loco swaps). The Bullion Bank’s balance sheet now looks like this:

Asset – 10 oz Loan to Refiner
Liabilities – 10 oz of Unallocated to Miner

Note, while the Bullion Bank does not hold one ounce of physical (more cries of "fraud"), the Refiner is holding physical, making their promise to repay the gold loan credible. The Miner needs cash, rather than gold, to pay wages and other expenses, so they enter the marketplace to sell their “gold”. As it happens there is an Investor who is interesting in holding some (unallocated) gold. There are cries of “no” from our audience, “don’t you know that paper gold is evil, don’t trust that bullion banker”, but our Investor ignores them and agrees a price with the Miner. The Miner instructs the Bullion Bank to transfer gold to the Investor. The Bullion Bank’s balance sheet now looks like this:

Asset – 10 oz Loan to Refiner
Liabilities – 10 oz of Unallocated to Investor

Meanwhile, the Refiner diligently works to turn the dore into 99.99% pure 1 oz gold bars. After one year (very inefficient), the Refiner delivers 11 x 1 oz gold bars to the Bullion Bank as repayment of the loan and interest of 10%. The Bullion Bank’s balance sheet now looks like this:

Asset – 11 oz of physical gold bars
Liabilities – 10 oz of Unallocated to Investor
Equity – 1 oz of retained earnings (interest profit)

Now many have been convinced that this is fractional fraud, but what would you say if the Refiner just issued the Miner with a real bill for 11 oz of gold and the Miner discounted that bill with the Bullion Bank for 10 oz of gold? While there are no bills issued, the process above in effect is no different to a gold real bill (see here for a discussion of real bills by Professor Fekete and I look forward to comments explaining why he is wrong). It is why Keith Weiner says that the gold lease rate is really a discount rate. People who understand the real bills doctrine may find it interesting that in the professional market, bullion banks charge a small fee on unallocated balances – discounting in another form perhaps?

The gold credit creation process above is in my opinion a legitimate function of bullion banking that facilitates the gold manufacturing and distribution business of getting gold into investors’ hands, a good thing we would all agree. The Investor in our example is saving in gold and financing the industry by the act of holding unallocated and deferring a desire for physical gold.

Our simple example can be expanded to many more participants, like bullion distributors and the like. Indeed, most of the Perth Mint’s large bank distributors pay for coins by unallocated credits and the Mint uses these unallocated credits to pay Miners for dore, which is made into coin and so on in a continuous flow. Another quote from Professor Fekete is relevant here to explain why this type of fractional bullion banking is OK (and 100% reserve banking is flawed):

“The notion that the bank's promise, if it is to be honest, forces it to have a store of gold on hand equal to the sum total of its note and deposit liabilities stems from a fundamental confusion between stocks and flows. The promise of a bank, as that of every other business, refers to flows, not stocks. The promise is honest as long as they see to it that everything will be done to keep the flows moving. In the case of the bank, the promise is honest as long as the bank carries only self-liquidating bills, other than gold, in the asset portfolio backing its note and deposit liabilities.”

Before some goldbugs start having cognitive dissonance with someone as respected as Professor Fekete is endorsing that which they have been told is bad, I would direct their attention to the last sentence in that quote. Bullion banking is only legitimate “as long as the bank holds only gold and self-liquidating bills [ie loans to the gold industry] to cover the bank note [ie unallocated] issue, it changes neither the supply of nor the demand for credit”. The problem is that much of the assets a BB holds do not fit this definition as they are not maturing into physical gold within a few weeks or months. It is my guess that while BBs are involved in this legitimate and useful banking function for the gold industry, it is only a small part of their assets, with the bulk of unallocated on call deposits being used to fund outright speculative short selling and much longer term financing (introducing maturity risk). You can rest easy in your hate of unallocated.

At this point I’ve learned my lesson and I am not going to commit to what I’m going to talk about tomorrow regarding fractional bullion banking and banks runs, as I’ll probably think of something else I’ve forgotten to mention. At this time, these are the topics I think I have left to cover:
  • The dynamics of a gold run on a single bank – who are the unallocated holders an how likely are they to “run” and can the BB's assets satisfy the demand for physical
  • Introduce multiple banks and inter-bank account transfers, settlement and clearing - bullion banking as freebanking
  • The role of central banks in inter-bank clearing and liquidity provision via paper leases vs physical leases – is it still freebanking?
  • Central bank support of bullion banking system vs individual BB support in a run (difference between domestic BBs vs overseas BBs?); free rider problem for the US?
Feel free to suggest any other topics for discussion around this gold bank run issue.


  1. "Bullion banking is only legitimate...

    No, not just bullion banking... all banking. A bill is only 'real' if it matures into gold within 90 days, or one season, full stop. Gold is the highest quality asset, the standard of value. Nothing else can regulate the quality of debt, hence the need for redeemability.

    I'll agree that the bullion bank may be the last vestige of the gold standard & real bills, but if even the Perth Mint doesn't think that bullion bank assets are good as gold, then bullion banking is anything but robust.


  2. Hello. There are far too many central banks which keep on printing bank notes without having the physical counter-party. It is just too easy and this is the reason why we are in such a deep crisis. As far as I am concerned, I only trust physical assets such as gold, silver or diamonds. I also work for Lingold.com, a swiss based online platform dedicated to private investors across Europe (including France, Switzerland, Italy, and the UK) to buy and sell vault stored gold coins & bullion. There is nothing better than real physical assets and bringing evidence that inventories are right through audits ... this is what we do and our customers are satisfied. Thanks for your blog,

  3. Thanks for the technical detailed explanations.

    What I still have trouble in understanding from my gut feeling: What is it about gold to have the market it does?

    I mean just to bank/trade useless little yellow rocks to make evergreen souvenirs from, it appears to me too big/expensive. On the other hand if it had the importance that the (selfproclaimed) gold experts dutchbags claim, it is much too small/cheap.
    From my gut feeling it is something in the middle, no fish, no meat.
    See what I mean?
    Greets, AD

  4. Seriously Advocado, if it's just a useless little rock, why are you wasting your time with it? Life is too short to waste your time.

    And I'm a self proclaimed gold expert douchebag, shit for brains.

  5. Now many have been convinced that this is fractional fraud, but what would you say if the Refiner just issued the Miner with a real bill for 11 oz of gold and the Miner discounted that bill with the Bullion Bank for 10 oz of gold?

    Maybe I don't understand but isn't the difference that a real bill has a maturity date, but unallocated gold doesn't, the specie can be demanded as soon as it has been acquired.

    For example let me change your example.

    Once we get to this part:
    Asset – 10 oz Loan to Refiner
    Liabilities – 10 oz of Unallocated to investor

    Now suppose the investor demands physical delivery of his gold before the refiner is done. He is bankrupt, seemingly because he has committed fraud.

    I mean this is actually obvious from the first balance sheet. What if right after getting his 10oz gold loan at 10% the refiner simply demands his gold. The bank's fraud is once again caught out.

  6. Hi Bron,

    It would be great if at some stage you could write some articles about silver.


  7. and this business about "Brown's bottom" where Gordon Brown sold UK gold, so they say "to probably bail out a bullion bank."

    In conjunction with what you are saying, Bron, why on earth should any bullion bank need to be bailed out? Or do you think that that rumour about Brown selling the gold to bail out a bullion bank is just nonsense?

    If you think it COULD be true, then how could this situation have arisen?? Thanks

  8. @AD,

    Gold becomes money when the "official" money gets into trouble. At other times, it's just raw material for pretty things.

    Right now, the official (fiat) money is falling off the cliff. Thus, the role of gold is changing to money. Some day it will also change back to just another rare raw material.

  9. OEB,
    Nice thesis, so for what do I spend my gold, when "official" money gets into trouble? And what in particular do you mean by "in trouble"? Any news we havent heard so far?

    "Right now, the official (fiat) money is falling off the cliff."

    Right now, $ & € are gaining strength, I really dont know what you talking about, except the same old stuff golddoomers have been talking about forever.
    You know Ferdinand Lipps & Prof.Fekete? Sure you do, you should read their really old stuff, it is basically a permant broken record throughout their whole lifes. It is getting to be a running joke about waiting for godot.
    Greets, AD

  10. @AD,

    No currency has survived money printing when it has been used for financing chronic public deficit spending. Ever.

    This time, 4 major currencies are doing it. Wanna bet against history?

  11. http://armstrongeconomics.com/2014/01/14/hyperinflation-is-it-even-possible/

    Yes I bet you, over what time frame? You're sure that you'll survive it?

    Lipps, didnt survive it, neither did Mises, nor Hayek, and probably ANOTHER is also dead by now.....
    but of cause, for you it will be different...

    Probably I know your answer, but, but my grand children will.... yes, right, good excuse.

  12. Meanwhile, what's that I see?--Why it's the sight of?---the sight of??---THE SIGHT OF GOLD WHOOOOOSHING IT'S WAY ACROSS THE PACIFIC POND!

    Who's that I hear?--Why it's the sound of billions of voices from China singing, "We are the goldbugs! WE ARE THE GOLD BUGS!--WE HAVE THE BRAINS, But You Guys Have---YOU GUYS HAVE---ONLY BRON!

    What's That I Smell?
    Why!---I Smell It Clearly Now! The Smell Of Musty Old Empty Western Bankster Vaults!

    They've Taken It All!---ALL!

    Of Course, How Many Freshly -Poured Kilos Is Still A Secret.

    Because, after all--As Confucius say, "why alert 'em?
    What they do not know won't hurt 'em.

  13. @ AdvocatusDiaboli

    You said, "Lipps, didnt survive it, neither did Mises, nor Hayek, and probably ANOTHER is also dead by now...."

    The circumstances are totally different since Another shared his thoughts! The US has embarked on a war of terrorism. They're invading, bombing and/or destabilizing any country that refuses to accept US dollars and/or refuses to open their markets to US corporations.

    This short 2 part series should help to explain the current mindset of the American empire:

    Petro-Currency Warfare: the petro-Dollar vs the petro-Euro (part 1)

    Petro-Currency Warfare: the petro-Dollar vs the petro-Euro (part 2)